The misguided war on interest-only loans

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Industry regulator, ASIC, recently completed the largest data collection project in its history to produce Report 516 – Review of Mortgage Broker Remuneration. A few years ago, ASIC’s deep dive into the financial planning industry resulted in the introduction in 2013 of the Future of Financial Advice (FoFA) reforms. With mortgage brokers now dominating the nation’s home loan industry, ASIC scrutiny was inevitable.

Encouragingly, ASIC largely gave the mortgage broking industry a clean bill of health. However, it had this to say about the increasing prevalence of interest-only loans:

“Compared to consumers going directly to lenders, we found that consumers going through broker channels obtained significantly more interest-only loans: for all eight lenders reviewed, brokers arranged at least 50% more interest-only loans… All other things being equal, loans with higher amounts, and/or interest-only terms, will cost the consumer more in interest and may take longer to pay down.”

The premise is that an interest-only loan is not in the borrower’s interest. This is not correct, as interest-only may be the best option and often substantially so. This is an example of one arm of government (ASIC) not talking to another (ATO) for consistent policy. Another regulator, APRA, is on the same page as ASIC when it recently introduced a requirement that interest-only loans comprise no more than 30% of new loans.

Broker-loans more sophisticated

The reason more broker-originated loans end up as interest-only loans is simple — brokers are doing a good job. The fact that bank branch-originated loans have fewer interest-only loans shows a lack of sophistication of some bank branch staff who sell mortgages.

In addition to minor and probably positive tweaking of brokers’ remuneration structure, the report stated in its executive summary that:

“Brokers play a very important role in the home loan market. They are responsible for arranging around half of all home loans in Australia. Consumers are increasingly turning to brokers to get help in obtaining a home loan — in 2012 brokers arranged 47.7% of home loans for the lenders in our review. In 2015, this increased to 54.3%.”

“From a competition perspective, brokers have the potential to: (a) play a valuable role in providing a distribution channel for lenders — especially smaller lenders — without their own distribution network (e.g. branches); (b) exert downward pressure on home loan pricing, by forcing lenders to compete more strongly with each other for business.”

That’s all good, but ASIC is wrong about interest-only loans. Australian taxation rules mean that for many owner-occupied borrowers the smartest structure is an interest-only loan. This appears counter-intuitive but it is a key point that needs spelling out. Here’s how it works.

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Open the option for first home to become an investment

Imagine Jack and Jill want to buy their first property, which will be owner-occupied. If they go to the local bank they will probably walk out with a principal and interest loan. A good broker, on the other hand, will make a careful assessment. If Jack and Jill have a poor record in managing their money (that is, high credit card balances, car loans, unimpressive savings) then, of course, a good broker will also suggest principal and interest repayments so they are at least chipping away at their debt.

If, however, the broker can see Jack and Jill have no personal debt and solid savings plus a promising employment future, they will ask, “Do you think this first home may one day become an investment property?” Good borrowers will often respond, “Yes, it is our hope we will buy a bigger home in the future and retain our first property as a long-term investment.”

So, the good broker will spell out how an offset account works and explain that rather than officially reducing the principal on their first home they are significantly better off paying interest-only repayments. They are effectively paying off the debt by accumulating cash in the offset account.

They will achieve two positives. In addition to reducing debt, they are accumulating a larger cash deposit for their future home in their offset account, and will, therefore, have a lower non-deductible debt. They will accrue greater tax benefits from their first property when it becomes an investment property with a deductible debt because the principal has not been eroded. They will only consider reducing the principal on their first property’s debt when their long-term home is debt-free. All debt is bad, but home-loan debt is worse than investment debt due to the latter’s tax deductibility.

Unnecessary frustration

I have met countless good borrowers who were approved for their first property loan via a bank branch and, thinking they were doing the right thing, paid down their principal significantly. It was only when they bought their long-term home that their accountant correctly advised that their first purchase is now not a good investment property. The borrower will protest, “No, it’s a great property” but the accountant will explain, “It has too much equity and you have too little cash so your new non-deductible home loan is too high.”

These borrowers are then forced to sell their first home and incur selling costs as well experiencing frustration that no-one explained the long-term implications of principal and interest repayments. This bad loan structure costs good borrowers much time and tears and needlessly diminishes their wealth.

If the government wants to reduce the number of interest-only loans, then fine, that’s their call. But they need first to restructure the tax system and not punish smart mortgage brokers helping quality borrowers. Alternatively, they could just leave things as they are. ASIC and APRA – meet the ATO. You should talk.

 

John Ruddick is CEO of Stanford Brown Home Loans, a mortgage broking firm. This article does not consider the circumstances of any individual borrower.

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9 Responses to The misguided war on interest-only loans

  1. Frank May 18, 2017 at 11:13 AM #

    But interest only loans allow borrowers to gear up more to push house prices higher and generate more sales commissions and trails for the mortgage brokers.

    • John Ruddick May 19, 2017 at 9:17 AM #

      Any mortgage broker who thinks they can grow their business by attempting to shove borrowers into larger than required loans (to increase their commission a fraction) will soon be looking for another line of work. Borrowers are not stupid.

  2. David D May 18, 2017 at 5:55 PM #

    Great point, John. I’ve never thought before about the potential of the first loan to become the investment loan and how that feeds into the initial structure.

  3. Gen Y May 18, 2017 at 6:59 PM #

    I think most people fall into this bucket though: “If Jack and Jill have a poor record in managing their money (that is, high credit card balances, car loans, unimpressive savings) then, of course, a good broker will also suggest principal and interest repayments…”

    Safer bet is paying down the mortgage unless some sort of ‘untouchable’ offset account can be established to play the same role as principal repayments would.

    • John Ruddick May 19, 2017 at 9:22 AM #

      You’re correct that most first home buyers should pay principal and interest repayments … but that still leaves a huge market of savvy first home buyers who unwittingly damage their financial prospects by paying principal and interest repayments. Each principal repayment is eroding the viability of their first home becoming a worthwhile long term investment property. A good strategy is to have two offset accounts – one for savings and which is not touched and the second is for daily expenses.

      • Kevin May 19, 2017 at 1:21 PM #

        Seems weird to me.So if I own a property mortgage free the rent is say $400 per week.The tax man takes circa 40% of that.That leaves me with $240.

        The ‘ savvy ‘ investor loses say $400 per week and duly gets a rebate of $160.I am $400 a week better off than the ‘savvy ‘investor.

        The ‘savvy’ investor loses his/her job.Disaster and possible bankruptcy,no way to repay the bank.

        I lose my job,low income but the property is self funding.

        I’m glad I have never been a ‘savvy ‘investor,I always wanted to be positively geared as quickly as possible.I never had a problem working out that if I had a $ and paid 40 cents tax on it, it left me with 60 cents.Spending that $ to get 40 cents back off the tax man was not a good idea..

        I own a house and then leave it and rent it out.,the $240 helps to pay my mortgage.I own 2 houses quicker, and at less cost than paying interest for evermore.

        What next, ,instead of living off a good income from investments I should sell them,buy a house for $4 million and then I can get the full pension.

        The mind boggles.

        Would the ‘savvy ‘ investor not just build up a good offset balance?Should they follow the experts advice and think that losing money to get a rebate is better than making money to pay tax,then good luck to them.

        I wish I was paying $3.5 billion in tax the same as CBA.I’m sure it would be a struggle trying to live on $9 billion a year in the pocket but I’d be prepared to give it a go.

      • John Ruddick May 21, 2017 at 11:04 AM #

        I am in agreement that negative gearing is overrated for many property investors … but that is not the point of this piece. The argument here is for a specific segment of borrowers – namely first home buyers who will reside in their first property for a few years and then lease out their first home because they have bought another home to live in. This is not a majority of the market for sure … but there are plenty of people who do fit into this category. If someone does then it is not up for debate – they are better paying interest-only on the first home and to effectively pay it off by accumulating cash in the offset. This will give them a larger cash deposit (and therefore non-deductible debt) on their future long term home. When the long term home is paid off in full then at that point we are largely in agreement – pay down the investment loan. The one caveat there is that some borrowers will prefer to divert their now increased cash flow (ie because they have no mortgage repayments over their home) to another form of investment. That other investment only needs to have a return that exceeds the interest rate on the mortgage for it to be preferable not to reduce the investment property mortgage. Of course, many borrowers simply prefer the security of paying off the debt rather than chasing a higher return … which is perfectly understandable.

  4. Kevin May 21, 2017 at 3:18 PM #

    Hiya John.

    For a select few,fair enough.

    For a short time to get over the shock of paying it,fair enough.

    Your caveat is fair enough,I think I paid off an investment loan 3 or 4 times.Line of credit, buy shares,use the DRP,pay the loan off and repeat.Thinking again the loan was only ever paid down to a small amount and then re drawn.

    Perhaps a first home buyer should live in the property for a year and then move back in with mum and dad to save even more.Mum and dad will not like me for that (lol)

    Sadly my bank only allows a $50 k offset now so the mortgage is $50k fully offset ,waiting for share prices to fall further.

    thanks

  5. Tortoise May 25, 2017 at 9:18 PM #

    “When the tide goes out, we will then see who is naked”

    The latest data regarding owner occupiers and their disposable income % dedicated to debt/mortgage repayments is startling.

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